Friday, December 14, 2012

The Fed's great experiment

So now you have it. QE4. The Fed will buy $85 billion of long term government bonds and mortgage backed securities, printing $85 billion per month of new money (reserves, really) to do it. That's $1 trillion a year, about the same size as the entire Federal deficit. It's substantially more each year than the much maligned $800 billion "stimulus." Graph to the left purloined from John Taylor to dramatize the situation.

In addition, the Fed's open market committee promises to

"..keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored." [Whatever "anchored" means.]

This is a grand experiment indeed. We will test a few theories.

First, just how much of the labor market's troubles are the result of an ill-advisedly long maturity structure of government debt? How much is the result of 2% long term rates (negative in real terms) being too high and strangling credit? (If, in fact the Fed's purchases have any sustained effect at all on long rates, which I doubt.) At zero interest rates does the split between reserves (which are, in the end, nothing more than floating-rate, overnight, electronic-entry US government debt) and other forms of government debt mean anything at all? In short, is monetary policy of the buy-bonds, print-money sort completely ineffective at zero rates, yes or no? At a trillion bucks a year we will soon find out. I bet no. (The WSJ calls this the "more cowbell" approach to policy.) But nobody can say it wasn't big enough to test the theory.

Second, just how much is the economy suffering from a lack of promises from appointed officials? "Oh, well, sure, now I'll build that new factory and start hiring people. I just wanted to hear that Bernanke 'anticipates' that he will think low rates are appropriate until until unemployment hits 6.5%, not just into the 6th year of the Biden administration."

Fashionable new-Keynesian models give a big role to such pronouncements. I'm dubious. Does the average Joe understand the difference between, say, the Administration's promises that sure, next year we'll cut entitlements, and the Fed's promises?

One big hole in the argument: Charlie Evans (Chicago Fed president) calls this "Odyssean" policy, after Odysseus who had himself tied to the mast so as to hear the sirens. But notice a big difference between Odysseus and Bernanke. Odysseus did not "anticipate that remaining near the mast will remain appropriate so long as the call of the sirens is not too beautiful, the sea not too rough, the sailors manning the rigging doing their jobs, and no other ships we might crash in to." Odysseus made an irreversible decision. Cortez burned his ships.

If you want people to believe you about the unemployment trigger, you have to remove the discretion to change your mind tomorrow if, say, the dollar crashes, Spain defaults, long term interest rates spike, the Chinese dump their bonds or whatever. Otherwise, we know it is all hot air. If they can decide in this meeting 6.5% is the right target, they can decide in the next meeting, "whoops, no, we'll print money until China starts buying Chevys." (Sorry, that will be mumbo jumbo about "illiquid conditions in sovereign credit markets and global imbalances..")

I'm not such a fan of new-Keynesian models (here, with hard academic article warning) so this lack of real commitment doesn't trouble me that much. I don't think we would get immediate benefit even from a completely credible tied-to-the-mast commitment to buy trillions of dollars until unemployment hits 6.5%. (I do think rules-based policy in general is a good idea, not this sort of discretionary commitment-making. But I can think of a lot better rules, like "the price level shall be CPI=130 forever, period.")

But we certainly will test whether this kind of open-mouth operation has any effect. My forecast: continued sclerosis, and, whatever happens, no evidence that these policies had any effect whatsoever.

Which puts me rather less critical of the Fed than many skeptics. I think money and bonds are perfect substitutes at the moment, so "no effect" means no hyperinflation either. The problems are not monetary, so the Fed is just trying to seem important though it's powerless. The major damage that I see in current policy is the implied shortening of the maturity structure of debt: If markets force interest rates to rise to 5%, the deficit doubles due to interest payments, and the US experiences a Greek death spiral. But nobody is even talking about that.

Greg Mankiw posted a back-of-the envelope calculation that Marty Feldstein did that under pretty much any plausible Taylor rule you can come up with, the Fed's promise to not raise rates until unemployment <6.5% or inflation > 2.5% is a promise of easier money than they've done in the past.

To me, this is a promise to tolerate higher future inflation. Which should boost inflation expectations now. Which should stimulate the economy, right?

Not necessarily. Standard Phillips curve theoretical models, and the experience of the 1970s, say that higher expected inflation shifts the Phillips curve and leads to more inflation with no change in unemployment or even stagflation. Underline "expected." Some new-keynesian models have this property, but it's not a no-brainer obvious proposition. More models and experience is consistent with an unexpected jump in inflation having a bit of stimulus until people figure it out. Sometimes. It's hard to fool people twice.

I am not an expert on these models. But it seems under the promise of higher inflation, investors will have to invest into higher yielding assets that can be hedges for inflation such as stocks and property, rather than treasury bonds and ultimately go into risk on mode rather than risk off mode - and that is going to boost the economy, no?

But if prices (esp. wages) are sticky, and if it's that nominal rigidity that's causing high unemployment right now (unless the natural rate has gone to 7.5%?!), why wouldn't increased inflation expectations have a stimulative effect?

If the government merely printed up money and gave every adult $1,000 to spend, then everything would be OK. Uh, make that $2,000 (consults a book by the late economist Keynes), I mean $4,000.

Well, that might not be enough, and we are in big trouble, so we ought to go big. Make that $10,000. There are about 250 million US adults, so that would be only $2.5 trillion. Well worth it to end our financial troubles.

(Voice from the back asks about distribution problems) Uh, yes. To do this immediately, we will pass a law that allows each adult to use his computer printer to print up his own $10,000. We will provide the file for download. If you don't have a printer, just write out 100 x $100 bills by hand, following this simple format. Neatness doesn't matter.

A notice to all shopkeepers and manufacturers: It is a sign of patriotism and intelligence to accept this new money in the same way that you would accept official money. Don't discriminate. That is an order.

To all workers: You must accept this money, no matter how poorly drawn, when offered to you as your wages.

Eventually, we will replace this amateur currency with official versions, so that you won't be able to tell the difference. Feel better?

The important thing is to get large amounts of money flowing around creating wealth each time it is spent. Buy a TV, or a few. Eat in restaurants. Go on vacation. Buy new furniture. This buying will get the ecnonomy moving again. Prosperity is just around the corner.

After this works, we'll do it again and again, until we are by far the wealthiest nation on earth, and twice as rich as we were before. This is suported by past, similar policy as evidenced by [ fill in examples before publishing ].

Or, if that multiplier is a fiction to support runaway taxation and spending by crafy, amoral politicians, then the Fed is applying the largest, most hidden stealth tax in human history, guaranteed to misallocate resources, distort prices, reduce retirement values, and produce years of poverty and misery.

If the ZLB is a constraint, it is a constraint because monetary policy is too tight and can't be accommodating enough. What's always struck me as strange about your position is that you think the ZLB is a constraint (the Fed can't create inflation), but that it's ok because monetary policy is about right (more accommodative policy wouldn't help the economy). It just seems like an amazing coincidence that the Fed would become impotent, but the economy is just healthy enough that there is no cost to that impotence.

And more, it seems like the view you've held, since the financial crisis in a period the underlying economy has changed a fair amount. [Though it did seem like early in the period you were more agnostic about whether special monetary policy which you wanted to call "fiscal policy" would help.]

RE: "But we certainly will test whether this kind of open-mouth operation has any effect. My forecast: continued sclerosis, and, whatever happens, no evidence that these policies had any effect whatsoever."

Just to be clear...by this statement are you saying that the Fed's QE program has no effect, or no positive effect?

According to his papers, in this environment where money and government debt are perfect substitutes: trading long for short term debt will change only the timing of inflation; trading cash for securities will do nothing at all (like the real bills doctine); and although there can be an effect from purchasing private debt there is a point (which I guess he believes we have long since passed) that there will be no more stimulative effects.

I guess there would still be risks that we should see to be priced into the market...like the risk of inflation through overly short term structure of debt...

Oh I think it will be a negative policy. Inflation is a potential hazard. Not hyperinflation, but when the economy does begin to accelerate there will be tremendous pressure on inflation and on interest rates. This is not good for a nation which has so much debt. The debt service will begin to eat up more and more of the Federal Budget.

i just got through most of your "determinacy and identification ..." paper and one thing is stuck in my head: when i was studying all those friedman rule models from the "ad hoc" zoo(CIA, MIU, OLG) was I ever supposed to be imagining a liquidity trap? WWFD?

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!